Section 1031 like-kind exchanges have been one of the California Franchise Tax Board’s (FTB) top audit issues in recent years. [i] California’s Form 3840, which is new for the 2014 tax year, is one of the latest developments in the FTB’s focus on scrutinizing like-kind exchanges.
On June 27, 2013, Assembly Bill 92 was enacted, which imposed a new information reporting requirement for taxpayers who engage in certain like-kind exchanges under section 1031 of the Internal Revenue Code (IRC).[ii] The new law creates an annual information reporting requirement for taxpayers who defer recognition of gain on an exchange of real property in California for property outside California.[iii] This requirement applies to exchanges that occur during tax years beginning on or after January 1, 2014, making this filing season the first time that taxpayers will be required to file the new California Form 3840, titled California Like-Kind Exchanges, which the FTB recently released in final form.[iv]
Section 1031 allows taxpayers to defer recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.[v] California generally conforms to IRC section 1031 under Revenue and Taxation Code (R&TC) sections 18031 and 24941, allowing taxpayers non-recognition treatment for California tax purposes for like-kind exchanges that meet the requirements of section 1031. The FTB has identified three general requirements to qualify for non-recognition treatment under section 1031: (1) there must be an exchange, as opposed to a separate sale and reinvestment, by the same taxpayer; (2) the relinquished property and the replacement property must be “like kind”; and (3) both the relinquished property and the replacement property must be held for investment or for productive use in a trade or business, which excludes property that is held primarily for sale or for personal use.[vi] Real property interests are generally considered to be of a like kind to each other, except real property located in the United States and foreign real property are not considered to be of like kind.[vii]
In a section 1031 exchange, a taxpayer’s basis in the replacement property is generally equal to the taxpayer’s basis in the relinquished property, with adjustments for cash received in the transaction and for gain or loss recognized at the time of the exchange.[viii] This creates a deferral of any gain until the replacement property is disposed of in a taxable transaction. When the taxpayer later sells the property in a taxable transaction, the taxpayer then pays tax on not only the appreciation on the property being sold, but also on the gain that was deferred in any earlier section 1031 exchange.
For state tax purposes, this creates the issue of how to source that gain, when part is attributable to a sale of a property in one state and part is attributable to a sale of property in another state. In general, capital gains and losses from sales of real property located in California are sourced to California.[ix] That means that the gain on the sale of any California real property is taxable by California, even if the taxpayer is a nonresident at the time of the sale or subsequently moves out of state.
In like-kind exchanges, the source of gain on the exchange of property is determined at the time the gain or loss is realized, i.e., at the time of the exchange. Where the relinquished property in a like-kind exchange is located in California, the deferred gain on the exchange is sourced to California, regardless of the residence of the taxpayer or the location of the replacement property.[x] California takes the position that the source of this gain or loss is preserved until the gain or loss is recognized — that is, when the replacement property is ultimately sold in a taxable transaction, the gain originally deferred on the California property will have its source in and be taxable by California.
In audits by the FTB of like-kind exchanges in recent years, the sourcing of gains to California is one of the audit issues that the FTB has been focused on.[xi] The FTB was having difficulty tracking a taxpayer’s replacement property to determine whether it was later sold in a taxable transaction, triggering a tax liability to California on the California-sourced portion of the deferred gain. This issue is made more complicated by the fact that taxpayers can engage in multiple consecutive section 1031 transactions, making it so the FTB would have no record of a subsequent exchange by a non-resident taxpayer that further deferred recognition of the gain.
To ensure that taxpayers do not escape California taxation on capital gains realized from the exchange of California real property, the new Form 3840 requires taxpayers to report to the FTB details about the relinquished properties, the replacement properties, and the amount and allocation of the taxpayer’s California source deferred gain. The form is designed to help taxpayers and the FTB keep track of California sourced gain deferrals from section 1031 exchanges and is required to be filed by the taxpayer on an annual basis until the deferred gain is recognized, even if the taxpayer does not otherwise have any California filing obligation for that year.[xii] This new filing requirement currently applies only to exchanges involving real property, not tangible personal property.
If a taxpayer fails to file a Form 3840, as required, the FTB may issue a Notice of Proposed Assessment that will adjust the taxpayer’s income to recognize the previously deferred gains, plus penalties and interest.[xiii]
As a result of the FTB’s heightened scrutiny and strict interpretation of the section 1031 requirements, certain exchanges may come under scrutiny by the FTB that would otherwise be respected for Federal tax purposes. In its most recent list of Top Audit Issues, published in April 2014, the FTB explained that it is continuing to find noncompliance in section 1031 exchanges in the following areas: (1) errors in computing gain, particularly taxable boot due to debt netting and including non-exchange expenses in the computation; (2) failing to properly comply with the section 1031 rules for identifying the replacement property; (3) including the cost of property improvements made after the exchange closed in the calculation of taxable boot; and (4) withdrawing cash out of the proceeds from the relinquished properties.[xiv] The FTB’s continued focus on section 1031 exchanges makes it especially important for taxpayers considering doing a like-kind exchange to pay careful attention to complying with all of the section 1031 requirements.
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is an associate at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.
[i] FTB April 2014 Tax News, https://www.ftb.ca.gov/professionals/taxnews/2014/April/Article_6.shtml (hereinafter April 2014 Tax News); FTB January 2013 Tax News, https://www.ftb.ca.gov/Archive/Professionals/Taxnews/2013/January/Article_5.shtml; FTB January 2012 Tax News, https://www.ftb.ca.gov/archive/professionals/taxnews/2012/january/article_2.shtml (hereinafter January 2012 Tax News).
[ii] FTB September 29, 2014 Public Service Bulletin, “New FTB Form for Like-Kind Exchanges,” https://www.ftb.ca.gov/aboutFTB/Public_Service_Bulletins/2014/27_09292014.shtml (hereinafter September 29, 2014 Public Service Bulletin).
[iv] FTB January 2015 Tax News, https://www.ftb.ca.gov/professionals/taxnews/2015/January/03.shtml. The new Form 3840 is available here: https://www.ftb.ca.gov/forms/2014/14_3840.pdf. Instructions to the Form 3840 are available here: https://www.ftb.ca.gov/forms/2014/14_3840ins.pdf.
[vi][vi] January 2012 Tax News.
[vii] IRC § 1031(h).
[viii] IRC § 1031(d)
[ix] Cal. Rev. & Tax. Code § 25125(a).
[x] 2014 Instructions for Form FTB 3840.
[xi] See, e.g., January 2012 Tax News.
[xii] FTB December 2013 Tax News, “New 1031 Filing Requirements for California,” https://www.ftb.ca.gov/Archive/Professionals/Taxnews/2013/December/Article_8.shtml
[xiii] September 19, 2014 Public Service Bulletin.
[xiv] April 2014 Tax News.